Question 3

7. Computing real exchange rates Suppose a fixed basket of consumer goods that costs $80 in the United States costs GHS 24 in Ghana. Under a constant cost of the basket in each country, compute the real exchange rates produced by the two nominal exchange rates given in the following table. Cost of Basket in U.S. Cost of Basket in Ghana MNominal Exchange Rate Real Exchange Rate (Dollars) (Cedis) (Cedis per dollar) (Baskets of Ghanaian goods per basket of U.5. goods) &0 24 1.50 [ ] g0 24 0.75 1 3. Effects of a government budget deficit Suppose a hypothetical open economy uses the LS. dollar as currency. The table below presents data describing the relationship between different real interest rates and this economy's levels of national saving, domestic investment, and net capital outflow. Assume that the economy is currently operating under a balanced government budget. Real Interest Rate National Saving (Percent) (Billions of dollars) 7 2w 50 45 40 35 20 25 Domestic Investment (Billions of dollars) 30 40 S0 &0 70 80 Net Capital Outflow (Billions of dollars) =20 -15 -10 -5 o Given the information in the table above, use the biue points (circle symbol) to plat the demand for laanable funds. Next, use the orange points (square symbal) to plot the supply of loanabie funds. Finally, use the black point (cross symbol) to indicate the equilibrium in this market. REALINTERESTRATE Market for Loanable Funds () Q) Demand Supply + Equilibrium =l t t 20 40 &0 B QUANTITY OF LOANABLE FUNDS 100 On the following graph, plot the relationship between the real interest rate and net capital outflow by using the green points (triangle symbol) to plot the points from the initial data table. Then use the black point (X symbol) to indicate the level of net capital outflow at the equilibrium real interest rate you derived in the previous graph. pital Outflow 10 A NCO .+ Eqm. NCO REAL INTEREST RATE -20 -15 -10 -5 0 5 10 15 20 NET CAPITAL OUTFLOW (Billions of dollars) Because of the relationship between net capital outflow and net exports, the level of net capital outflow at the equilibrium real interest rate implies that the economy is experiencing Now, suppose the government is experiencing a budget deficit. This means that , which leads to loanable funds. After the budget deficit occurs, suppose the new equilibrium real interest rate is 7%. The following graph shows the demand curve in the foreign- currency exchange market.5. Capital flight The graphs below depict the loanable funds market and the relationship between real interest rates and the level of net capital outflow (NCO) calculated in terms of the Mexican peso. (? ) (?) The Market for Loanable Funds in Mexico Mexican Net Capital Outflow Supply ch ch REAL IN TEREST RATE (Percent) REAL IN TEREST RATE (Percent) NCO Demand N 0 2 4 3 2-1 0 1 2 3 5 LOANABLE FUNDS (Billions of pesos) NET CAPITAL OUTFLOW (Billions of pesos) Complete the first row of the table to reflect the state of the markets in Mexico. Real Interest Rate Net Capital Outflow (NCO) (Percent) (Billions of pesos) Initial state After capital flightSuppose now that a sudden bout of political turmoil in Mexico causes world financial markets to become uneasy. Because investors now see Mexico as unstable, they decide to pull a portion of their assets out of Mexico and put them into more stable economies. This unexpected shock to the demand for assets in Mexico is known as capital flight. Shift the NCO curve to illustrate the effect of capital flight. Then, on the graph representing the market for loanable funds, shift the supply curve, the demand curve, or both curves to reflect the change caused by the shift in NCO. Note: You will not be graded on your final placement of the curves on the graph, but you will need to shift them correctly in order to answer the questions that follow. Determine the equilibrium interest rate after capital flight occurs, and enter it into the second row of the table. Then determine the level of NCO that occurs along the new NCO curve at the new equilibrium interest rate. Finally, show the effect of the change in NCO on the market for foreign exchange by shifting either the supply curve, the demand curve, or both. The Market for Foreign-Currency Exchange Supply Demand Supply REAL EXCHANGE RATE ( Dollars per peso) Demand QUANTITY OF PESOSSummarize the results of capital flight by completing the following table. Real Interest Rate Real Exchange Rate Net Capital Outflow Effects of capital flight - - 0w - T e Use the green line (triangle symbol) to show the supply curve in this market before the budget deficit. Then use the purple line (diamond symbol) to show the supply curve after the budget deficit. Market for Foreign-Currency Exchange 10 A Initial Supply O Supply with Deficit REAL EXCHANGE RATE Demand -20 -15 -10 10 15 20 QUANTITY OF DOLLARS (Billions) Summarize the effects of a budget deficit by filling in the following table. Real Interest Rate Real Exchange Rate Trade Balance Effects of a Budget Deficit Grade It Now Save & Continue